Editor’s Note: This post is by Fabrizio Ferri of the NYU Stern School of Business.

Executive pay is taking center stage in the governance reform debate, with significant attention given to a proposal to mandate an annual advisory shareholder vote on the executive compensation report, known as “say on pay,” following the example of United Kingdom (U.K.). I have recently completed two studies examining this proposal—the first considers the impact of “say on pay” in the U.K., and the second analyzes the effect of mechanisms currently available to U.S. investors to influence executive pay (i.e. shareholder proposals and vote-no campaigns).

In the first study, co-authored with David Maber of University of Southern California, Say on Pay Votes and CEO Compensation: Evidence from the UK, we perform two sets of tests. First, we examine UK firms’ responses to say on pay votes by analyzing the changes to compensation policies made by firms after facing high voting dissent against their remuneration report. We document that a significant number of these firms removed or modified provisions that investors viewed as “rewards for failure” (e.g., generous severance contracts, low performance hurdles, provisions allowing the retesting of performance conditions)—often in response to institutional investors’ explicit requests—and established a formal process for proactive consultation with their major shareholders going forward. These actions paid off, in that voting dissent at the subsequent annual meeting was substantially lower. We also find evidence of similar actions taken before the vote by a subset of firms that subsequently experienced low voting dissent, suggesting that the threat of a vote induced some firms to revise CEO pay practices ahead of the annual meeting.

Second, we examine the trend in CEO pay and its sensitivity to economic determinants before and after the introduction of say on pay for a large sample of UK firms. We find no evidence of a change in the level and growth rate of CEO pay—after controlling for firm performance, size and other factors. However, we find a significant increase in the sensitivity of CEO pay to poor performance. The increase is most pronounced in (i) firms with high voting dissent, and (ii) firms with an ”excessive” level of CEO pay (relative to the level predicted by its economic determinants) before the adoption of say on pay, regardless of the voting dissent. Interestingly, we do not find a more pronounced increase in firms with higher raw levels of CEO pay. These findings confirm the insights from our small-sample evidence of explicit changes to pay contracts and suggest the following: (i) UK investors used say on pay to push for greater accountability for poor performance; (ii) firms responded to adverse shareholder votes, in spite of their non-binding nature; (iii) (at least some) firms responded to the threat rather than the realization of an adverse vote; (iv) shareholders focused on firms with controversial CEO pay packages (as captured by high voting dissent or excessive CEO pay levels) rather than firms with high (but not abnormal) CEO pay levels.

In the second study Shareholder Activism and CEO Pay, coauthored with Yonca Ertimur of Duke University and Volkan Muslu of the University of Texas at Dallas, we examine a comprehensive sample of 1,332 compensation-related shareholder activism events over the 1997-2007 period (134 vote-no campaigns and 1,198 shareholder proposals). We find that, in targeting firms, activists take both the ”predicted” and ”excess” components of CEO pay into consideration. In other words, activists (particularly institutional investors) appear sophisticated enough to identify excess CEO pay firms, but they also target firms with high (but not abnormal) levels of CEO pay, perhaps to bring greater visibility to their initiatives or because of concerns with social equity. Voting support for compensation-related proposals, in contrast, is higher in firms with excess CEO pay but not in firms with high (but not abnormal) CEO pay, suggesting that shareholder votes reflect a sophisticated understanding of CEO pay figures. Voting patterns depend on the type of shareholder proposal. In particular, proposals aimed at affecting the pay setting process (e.g., proposals requesting shareholder approval of certain compensation items)—which we label Rules of the Game proposals—receive the highest voting support, often resulting in majority votes. Support for proposals aimed at influencing the output of the pay setting process (e.g., proposals to use performance-based vesting conditions in equity grants)—which we label Pay Design proposals—is lower but has been increasing in recent years. Proposals directed at shaping the objective of the pay setting process (e.g., proposals to link executive pay to social criteria or to abolish incentive pay)—labeled Pay Philosophy proposals and mostly filed by individuals and religious funds—have consistently received little support. The rate of implementation for pay-related proposals is generally low (5.3%) but increases substantially for proposals receiving a majority vote (32.2%) most of which are Rules of the Game proposals. With respect to the overall effect on CEO pay, we document a $7.3 million reduction in excess CEO pay for firms targeted by vote-no campaigns, corresponding to a 38% decrease in CEO total pay. As for shareholder proposals, we find evidence of a moderating effect on CEO pay—a $2.3 million reduction—only in firms targeted by Pay Design proposals sponsored by institutional proponents in recent years.

What do these studies tell us about the potential impact of “say on pay” in the U.S.? While drawing policy implications requires caution, a few lessons can be learned. First, there is no indication that special interest groups pushing for radical changes have hijacked shareholder votes in the U.K. or the U.S.—a concern expressed by critics of say on pay. U.S. shareholders have systematically rejected proposals trying to micromanage executive pay and supported those that ask for a say on the pay process. Similarly, U.K. shareholders have shied away from opining on pay levels and focused instead on strengthening the link between pay and performance by imposing certain rules of the game (e.g., no retesting of performance conditions). Second, in both countries, investors use their voting power in a moderate and sophisticated manner, raising their voice only at few firms with controversial pay practices and suspiciously high pay levels. Fears that many firms would face massive chaos and revolts at annual meetings have not materialized. Third, while both in the U.S. and the U.K. boards do listen to shareholder votes, even if advisory, say on pay votes and vote-no campaigns are more effective in getting boards’ attention than shareholder proposals. A say on pay vote against the remuneration report (or votes withheld from a director) greater than 20% usually prompts a firm’s response. In contrast, shareholder proposals have a reasonable (but still low) chance to be implemented only if they win a majority vote. This difference is not surprising. Vote-no campaigns and say on pay directly question directors’ performance and, thus, affect their reputation. In addition, unlike shareholder proposals, they enable shareholders to express their general dissatisfaction with CEO pay rather than with a single problem and do not require an ex ante agreement on the solution. As such, they may force a broad dialogue between investors and boards on all aspects of CEO pay, without putting shareholders in the difficult position to micromanage specific and technically complex aspects of CEO pay through a 500-word “yes or no” proposal. The fourth lesson is that the U.K. experience with say on pay indicates that boards try to prevent an adverse voting outcome through ex ante consultation with institutional investors and that enhanced communication is crucial for boards to “interpret” the say on pay vote.

Overall, these factors suggest that concerns with say on pay may have been exaggerated. Say on pay may be as effective as vote-no campaigns in causing boards to listen and act, and with an added benefit. Specifically, say on pay may allow greater activism by those institutional investors concerned with CEO pay but reluctant to compromise their relation with boards by engaging in vote-no campaigns and voting against the re-election of otherwise valuable directors.

However, a number of caveats are in order, particularly in drawing inferences from the experience of a different country with its own governance environment. First, for say on pay to work investors must have something to say in the first place. In the U.K., institutional investors have developed and agreed upon (and continue to update) a set of guiding principles, or “best practices,” on executive remuneration, complementing the principles in the Combined Code. Under the U.K. “comply or explain” governance model, these best practices provide firms and shareholders with a clear benchmark against which to make assessments of pay practices. In addition, concentrated institutional ownership has led to a relatively high level of engagement which also allows for firm-specific adjustments of these best practices. It is not clear whether institutional investors in the US will take such a proactive role or outsource it to proxy voting services, which may be tempted to adopt “cheap” one-size-fits-all solutions, as cautioned by Jeffrey Gordon of Columbia Law School in a piece in the Harvard Journal on Legislation. In addition, higher concentration and stability of institutional ownership may make communication with boards easier in the U.K. Second, in the U.K. it is generally easier for investors to replace directors, thereby making directors more responsive to shareholder pressure (though the trend toward majority voting and proposed proxy access legislation may make the threat of replacement stronger in the U.S.). In view of these and other caveats, proposals to limit mandatory say on pay to large firms may be a sensible first step (after all, our studies show that most compensation-related activism is focused on the largest firms).

A final word of caution: in the heat of the reform debate, say on pay has often been used in the same sentence as excessive risk-taking to suggest that an advisory shareholder vote would lead to compensation packages that discourage excessive risk-taking. Such a statement is incorrect. Say on pay is a neutral tool that shareholders will use (if they decide to use it) to influence compensation practices in a way consistent with their objectives. The risk-taking profile desired by shareholders may very well differ from the level of risk-taking that regulators may deem optimal for the economy. Similarly, say on pay should not be expected to be a tool to deal with wealth inequality. After all, shareholders have long supported compensation packages that have encouraged risk-taking and resulted in higher compensation levels.

Editor’s Note: This post is by J.W. Verret of the George Mason University School of Law.

In my recent paper, currently in the submission process, Treasury Inc.: How the Bailout Reshapes Corporate Theory and Practice, I explore the implications of the U.S. Treasury Department and the Federal Reserve’s controlling ownership positions in many companies through its decision to take equity in TARP bailout participants. I show how existing corporate theory is unprepared for the presence of a controlling government shareholder and I demonstrate a variety of unanticipated complications for corporate practice. I close with three recommendations, one of which has assisted Senators Corker and Warner in introducing implementing legislation.

Corporate law theory and practice considers shareholder relations with companies and the implications of ownership separated from control. Yet through the TARP bailout and the government’s resultant shareholding, ownership and control at many companies has merged, leaving corporate theory and practice for the financial and automotive sectors in chaos. The government’s $700 billion bailout is a unique historical event; not merely because of its size, but because of the resulting ripple through scholarship and practice.

To emphasize the unique nature of Treasury’s ownership through TARP, the article briefly considers the history of the United States government’s entanglement in private business. Though the federal government has frequently chartered businesses that were wholly owned by the United States, the government’s ownership in businesses through TARP is a circumstance without precedent. Before rethinking theoretical and practical elements of corporate theory, the article will consider the two threshold questions in the analysis: whether Treasury and the Federal Reserve are actually controlling shareholders, and whether there are any substantive limits to their sovereign immunity as control shareholders under corporate and securities law.

The article argues that the government is most clearly a control shareholder for the largest TARP recipients in which it holds an interest, including Citigroup, AIG, GM, Fannie Mae, Freddie Mac, and with some significant measure of certainty the nine remaining banks from among the top nineteen banks to originally receive TARP funding. The article also offers the suggestion that the government might, depending on its degree of ownership, also be considered a control shareholder for many of the other 600 banks accepting TARP funding.

The article then considers the application of sovereign immunity to the Treasury and Federal Reserve’s exercise of ownership. After considering a number of novel challenges to the government’s sovereign immunity, it concludes that the federal government’s belt-and-suspenders protection from liability, including the liability waivers of the Emergency Economic Stability Act, waivers included in the Securities Exchange Act, and challenges in using sovereign immunity exceptions like the Takings Clause, foreclose meaningful challenge to the federal government’s sovereign immunity in its exercise of ownership power over its TARP shares.

This work updates the six central theories of corporate law to reveal that none function adequately when considered with a controlling government shareholder that enjoys sovereign immunity. Corporate law theory is home to essentially six distinct and at times vigorously opposed schools of thought. First, the article looks to the foundations of corporate law in agency theory and nexus-of-contracts theory. In both, it considers the effects of a control shareholder with sovereign immunity. Then, it considers the Cain-and-Abel-like warring children of the agency and nexus-of-contracts marriage: shareholder primacy and director primacy. Shareholder primacy is a difficult fit, as it contemplates a non-conflicted shareholder electorate that minimizes the special interest director problem, a wash-board which TARP ownership obviously complicates. Director primacy seems an easy critic of TARP ownership, as it is inherently hostile to the accretion of shareholder power, and yet is difficult to understand in light of elected directors who may be beholden to government shareholders.

The team production model theory of corporate law is also considered in the article, with the result that the model’s reliance on the board of directors as a mediating hierarch, balancing the interests of varying stakeholders, is complicated by the political pressures placed on the unique government shareholder hierarch. The progressive corporate law model of corporate law is also considered, with the result that the accountability of government regulators and the disclosure rules underlying progressive corporate law are threatened by the presence of government ownership.

The article also develops an economic model of incentives facing political decision-makers in exercise of their shareholder power. It gives particular emphasis to the fact that retail shareholders and taxpayers, as more dispersed interest groups, will have substantially less influence than other rent seeking groups. It also considers the fact that rents for an official exercising government shareholder powers aren’t time discounted, but the costs of using a bank to subsidize interest groups are substantially time discounted. Indeed, given the average two year tenure of a Schedule C appointee, the government appointees may be gone long before the costs of subsidization are revealed.

The article warns that i) Treasury has free reign to engage in insider trading of its shares pursuant to unique provisions in the ’34 Act ii) Treasury is the only control shareholder that evades fiduciary duties to other shareholders under corporate law, iii) Treasury may end up serving as a lead plaintiff in private securities class action litigation against the very companies it is trying to support through TARP, iv) unregistered securities of any TARP recipient held by another TARP recipient may be considered affiliated sales by virtue of their sharing a controlling shareholder v) the ability of boards of directors to approve conflicted transactions may be endangered, and vi) the government will obtain the right to nominate candidates for the Board of publicly traded companies, and vote for other shareholder’s nominees, under the SEC’s recent shareholder proxy access rule.

The article offers hope to the concerned corporate law traditionalist in three unique reform suggestions. First, it recommends that the government eschew its voting common equity, and even its non-voting preferred shares, in favor of frozen options. Frozen options would be designed such that the government would never be permitted to exercise them, and accordingly never be permitted to exercise the voting or other rights that accompany either common or preferred shares, but the government would be permitted to sell them into the market and allow other shareholders to exercise all the rights that accompany the form of shares into which those temporarily frozen options morph. This should serve as a significant buffer to the analysis that the federal government holds a control position in TARP companies, central to the article’s analysis concerning the resultant complications in corporate theory and practice, while still permitting the taxpayer to participate in share appreciation of bailed-out companies.

Second, the article recommends that the Treasury and the Federal Reserve set up trusts to hold its ownership that create an explicit obligation of those entities to maximize long term shareholder wealth in the invested TARP companies. Toward that end, the article’s author has contributed language to implementing bi-partisan legislation introduced by Senator Corker and Senator Warner, the TARP Recipient Ownership Trust Act of 2009. This should be accompanied by a waiver of the federal government’s sovereign immunity with respect to state corporate law, as well as a waiver of its immunity under section 3(c) of the Exchange Act and attendant immunity provisions of the Emergency Economic Stability Act.

Third, in conjunction the preceding recommendations, the article suggests that the federal government as a shareholder should execute a 10b-5 trading plan similar to the type filed by executives to protect against liability for insider trading. This plan should be binding on the Treasury by law, with appropriate ranges of trade amounts, to minimize the threat of insider trading by the Department and cement a near term exit date by the government from its positions in private businesses.

Editor’s Note: This post is by René Stulz of the Ohio State University Fisher College of Business.

Throughout the world, many large banks have seen most of their equity destroyed by the crisis that started in the U.S. subprime sector in 2007 and governments have had to infuse capital in banks in many countries to prevent outright failure. Many observers have argued that ineffective regulation contributed or even caused the collapse. If that is the case, we would expect differences in the regulation of financial institutions across countries to be helpful in explaining the performance of banks during the credit crisis. Other observers have criticized the governance of banks and suggested that better governance would have led to better performance during the crisis. Finally, it could be that banks were affected differentially simply because they had different balance sheets and profitability before the crisis for reasons unrelated to governance and regulation and that these characteristics affected their vulnerability to large adverse shocks. In a paper recently posted on SSRN titled “Why did some banks perform better during the crisis? A cross-country study of the impact of governance and regulation,” Andrea Beltratti and I investigate the possible determinants of bank performance, measured by stock returns, during the crisis for a sample of large banks, i.e., banks with assets in excess of $50 billion at the end of 2006, across the world.

One striking result is that banks with the highest returns in 2006 had the worst returns during the crisis. More specifically, the banks in the worst quartile of performance during the crisis had an average return of -87.44% during the crisis but an average return of 33.07% in 2006. In contrast, the best-performing banks during the crisis had an average return of -16.58% but they had an average return of 7.80% in 2006. This evidence suggests that the attributes that the market valued in 2006, for instance, a successful securitization line of business, exposed banks to risks that led them to perform poorly when the crisis hit. The market did not expect these attributes to be a source of weakness for banks and did not expect the banks with these attributes to perform poorly as of 2006.

An OECD report argues that “the financial crisis can be to an important extent attributed to failures and weaknesses in corporate governance arrangements”. We find no evidence supportive of such a statement in our data. There is no evidence that banks with better governance, when governance is measured with data used in the well-known Corporate Governance Quotient (CGQ score) perform better during the crisis. Strikingly, banks with more pro-shareholder boards performed worse during the crisis.

We use the database on bank regulation developed in Barth, Caprio, and Levine (2001, 2004) to examine the hypothesis that stricter regulation prevented bank losses during the crisis. We use indicators for the power of the regulators, oversight of bank capital, restrictions on bank activities, and the independence of the supervisory authority. When we compare the banks in the top quartile of return performance to those in the bottom quartile, the better performing banks have more restrictions on their activities, stronger oversight of bank capital, and a more independent supervisory authority. In multiple regressions, we generally find that a stronger supervisory authority has a negative impact on performance during the crisis and stronger bank capital oversight is associated with better performance. We interpret the negative coefficient on the strength of the supervisory authority as follows. If stronger supervisory authorities would have been more effective at preventing banks from taking risks before the crisis, we would expect a positive coefficient on that variable. A possible explanation for this negative coefficient is that once the crisis was ongoing, stronger regulators took more measures that were costly to shareholders to assure the survival of banks.

Bank balance sheets and bank profitability in 2006 are more important determinants of bank performance during the crisis than bank governance and bank regulation. Banks that had a higher Tier 1 capital ratio in 2006 and more deposits generally performed better during the crisis. As a result, the positioning of banks as of the end of 2006 is more important than governance and/or regulation in explaining the performance of banks during the next two years. Another way to explain our results is that banks were differentially exposed to various risks by the end of 2006. Some exposures that were rewarded by the markets in 2006 turned out to be unexpectedly costly for banks the following two years. Overall, the explanatory power of regulatory variables is small compared to the explanatory power of bank-level variables.

Overall, our evidence shows that bank governance, regulation, and balance sheets before the crisis are all helpful in understanding bank performance during the crisis. However, banks with more shareholder-friendly boards, which are banks that conventional wisdom would have considered to be better governed, fared worse during the crisis. Either conventional wisdom is wrong, as suggested by Adams (2009), or this evidence is consistent with the view that banks that took more risks rewarded by the market –perhaps because the market did not assess them correctly ex ante – before the crisis suffered more during the crisis when these risks led to unexpectedly large losses. Strong evidence supportive of the latter interpretation is that the performance of large banks during the crisis is negatively related to their performance in 2006. In other words, the banks that the market rewarded with largest stock increases in 2006 are the banks whose stock suffered the largest losses during the crisis.

The FDIC issued yesterday its final policy statement on private equity investments in failed banks. In early July, the FDIC issued a proposed policy statement containing stringent restrictions on these types of transactions. While the final policy statement relaxes some of these limitations, it continues to impose significantly higher requirements for private equity investors seeking to acquire failed banks than for strategic acquirors.

• Scope. Although the FDIC’s policy is generally viewed as focused on private equity investments, the policy is worded more broadly and applies to “private investors” – a term which is not defined in the policy. The earlier proposal applied to “private capital investors” and contained language, which has since been omitted, that made it clearer that the focus was private equity investors. In contrast, the policy statement does not apply to, and in fact encourages investment structures where private equity investors acquire a failed bank in conjunction with a bank or thrift holding company with a successful track record where the bank/thrift holding company has a strong majority interest in the resulting bank or thrift.

• Capital Support. Investors will be required to commit that an acquired depository institution be capitalized at a minimum 10% Tier 1 common equity ratio for at least three years following acquisition. The FDIC had previously proposed a minimum 15% Tier 1 leverage ratio – a higher number but a different measurement. The Tier 1 common equity ratio was a key measurement for the recent stress tests conducted by the Federal Reserve on the largest U.S. banks, but before then was not typically used as an explicit measure of regulatory capital. (In order to pass the stress test, banks were required to have sufficient common equity to achieve a Tier 1 common equity ratio of at least 4% at year-end 2010 under a hypothetical economic scenario.) Under the FDIC’s final rules, failure to meet the 10% Tier 1 common equity ratio would result in the institution being treated as “undercapitalized” for purposes of Prompt Corrective Action. This designation triggers strong regulatory measures, such as a requirement that the institution file a capital plan, restrict the payment of dividends and restrict asset growth.

• Source of Strength. Previously, the FDIC had proposed that investment vehicles would be expected to serve as a source of strength for their subsidiary depository institutions and would be expected to sell equity or engage in capital qualifying borrowings as necessary. The final policy does not contain this requirement.

• Cross Support of Affiliated Institutions. Investors and investor groups whose investments constitute 80% or more of the investments in more than one depository institution must pledge to the FDIC their proportionate interests in each such institution to pay for any losses to the Deposit Insurance Fund resulting from the failure of, or FDIC assistance provided to, the other affiliated institutions.

• Minimum Holding Period. Investors are prohibited from selling or otherwise transferring securities of the investors’ holding company or depository institution for a three-year period following the acquisition, unless the FDIC has approved the sale or transfer.

• Bar on Affiliate Transactions. All extensions of credit to investors, their investment funds, and any of their affiliates, by a depository institution acquired from receivership are prohibited.

• Bank Secrecy Law Jurisdictions. Investment structures involving entities domiciled in bank secrecy jurisdictions would not generally be eligible to own an interest in a depository institution acquired from receivership, unless they are subsidiaries of companies located in countries that exercise comprehensive consolidated supervision as recognized by the Federal Reserve and commit to provide extensive information to the FDIC.

• Ability of Existing Investors to Bid on a Failed Depository Institution. Investors that hold 10% or more of the equity of a depository institution that fails would not be eligible to bid on the institution once it is in receivership.

• Extensive Disclosure. Investors would be expected to submit to the FDIC detailed information about themselves, all entities in the proposed ownership chain, the size of the capital fund or funds, their diversification, the return profile, the marketing documents, the management team and the business model.

Private equity investors already face significant regulatory obstacles in bidding on failed banks. Since becoming a bank or thrift holding company and submitting to consolidated regulatory supervision is not practical for most private equity investors, investors need to satisfy the Federal Reserve (in the case of bank acquisitions) and the Office of Thrift Supervision (in the case of thrift acquisitions) that they will restrict themselves to largely passive roles. At the same time, they strive to ensure the placement and maintenance of competent management with the wherewithal to engineer a turnaround. There remain powerful arguments for the banking system to tap the investment resources available to private equity. Whether the FDIC’s final policy has changed enough to permit private equity to participate in acquiring failed banks remains to be seen.

(Editor’s Note: This post is based on an op-ed piece by Lucian Bebchuk published today on Wall Street Journal Online and available here.)

Financial firms seeking to attract and retain talent are reported to be making a substantial use of guaranteed bonuses, and the French Economy Minister recently called for limits on guaranteed bonuses. While many now focus on how using guaranteed bonuses affects the level of pay, it is important to recognize their effect on incentives. Guaranteed bonuses create perverse incentives to take excessive risks, and they consequently could well be worse for incentives than straight salary.

Introducing a guarantee into a bonus plan eliminates some downside risk but leaves the bonus compensation sensitive to performance on the upside. At first glance, a bonus plan with such a guarantee seems superior in terms of incentives to a fixed payment that isn’t sensitive to performance on either the upside or the downside. A closer inspection, however, reveals that the incentives produced by such a plan could well be counter-productive.

Consider a bank that sets annual compensation for an executive running a trading unit that is expected to generate between zero and $100 million in profit at the end of the year. Suppose that the bank was initially considering a fixed salary of $1 million and a bonus plan rewarding the executive with $1 million for each $10 million of profit – a plan that, depending on the unit’s performance, would provide the executive with an amount between $0 and $10 million. And assume also that, concerned about losing the executive to competitors, the bank decides to guarantee the executive’s getting a bonus of at least $5 million and thus a total compensation of at least $6 million.

The introduction of a $5 million floor for the bonus would insulate the trader from the downside risk of low profit levels: the trader would get the same bonus amount of $5 million whether the unit’s profits are zero or $50 million. But the bonus plan would still give the trader an incentive to seek a high profit level: the trader’s bonus would increase by $5 million if the profit is $100 million rather than $50 million.

Thus, compared with an average performance of $50 million in profits, the compensation structure under consideration would produce an extra $5 million in the event of stellar performance but not reduce compensation in the event of poor performance. As a result, the executive’s interest will be served by taking a bet that would increase the odds of a $100 million profit even if the bet would produce an even higher increase in the odds of no profit.

Indeed, taking as given that it’s necessary to provide the executive with a $6 million floor on compensation, a $1 million salary together with a guaranteed $5 million bonus would produce worse risk-taking incentives than a salary of $6 million coupled with a bonus plan that would reward the executive with $500,000 for each $10 million of the unit’s profits. Although this bonus plan would also reward the executive with an extra $5 million in the event profits reach $100 million , it would make the bonus compensation sensitive both on the upside and the downside. As a result, this bonus plan won’t distort risk-taking choices: the executive would take a risk only if doing so would increase the odds of a good outcome by more than it would raise the odds of a bad outcome.

The above discussion has implications that go beyond the question of guaranteed bonuses. It’s now well recognized that bonus plans based on short-term results which may turn out to be illusory can produce excessive risk-taking, and that plans should therefore be structured to account for the time horizon of risks. But even though tying bonus plans to long-term results is desirable, it isn’t sufficient to avoid excessive incentives to take risks. Bonus plans tied to long-term results can still produce such incentives if they reward executives for the upside produced by their choices but insulate them from a significant part of the downside.

Bonus plans that provide executives with such insulation from downsides – either by establishing a guaranteed floor or otherwise – can seriously backfire. Firms setting bonus plans, and regulators monitoring compensation structures, would do well to recognize and pay close attention to this problem.

(Editor’s Note: This post by Richard A. Posner is the second part of a two-part series, and is based on a recent article in Lombard Street; the first part was posted on the Forum here.)

If the proposals in the Obama Administration’s report on financial regulatory reform are adopted, the restriction on the size or form of executive compensation on Tier 1 Financial Holding Companies (FHCs) may be the one that most alarms financial enterprises. Let me turn to that issue.

We should separate issues of compensation of CEOs and other top management from issues concerning the compensation of traders, loan officers, and other financial executives at the operating rather than the management level. The Federal Reserve would be authorized to regulate compensation at both levels, but at the top level the aim would be to make management a more faithful agent of the shareholders, while at the operating level it would be to curb the risk‐taking incentives of financial executives by requiring that much of their compensation be deferred. The deferred component might consist of restricted stock that could not be sold for a period of years. Or the deferred component might consist of cash bonuses that could be recovered by the company if the deals for which the bonuses were a reward later soured.

The two aims—better aligning executives’ incentives with those of the shareholders, and reducing the riskiness of executives’ compensation—are inconsistent. Shareholders are generally less risk averse than executives because they have less stake in the enterprise, as they can diversify away any risk that is peculiar to the enterprise by holding a diversified portfolio of securities. Top executives have much more to lose, in reputation and future earnings prospects, from the collapse of their company.

That means that top executives, provided that they are allowed by the Federal Reserve to remain imperfect agents of the shareholders, have strong incentives to establish procedures that will prevent traders, loan officers, and other subordinate executives from taking excessive risks. But “excessive” from the standpoint of private businessmen means something crucially different from “excessive” as perceived by the Federal Reserve. Risks, including the risk of bankruptcy, that are cost‐justified from a corporation’s standpoint may be unacceptable from a broader social standpoint because of their potential for bringing down the entire financial system, and in its wake the nonfinancial economy as well. But the measures that have been suggested for reducing risk‐taking by traders and other financial executives have their own problems. Many things can affect a stock’s price besides a trader’s deals, as critics of stock options as devices for compensating top executives point out, and retractable cash bonuses (would they have to be placed in escrow?) make it difficult for recipients to manage their finances.

In our paper, Using Nonfinancial Measures to Assess Fraud Risk, which is forthcoming in the Journal of Accounting Research, we investigate whether publicly available nonfinancial measures (NFMs), such as the number of retail outlets, warehouse space, or employee headcounts, can be used to assess the likelihood of fraud.

More specifically, we test whether inconsistencies between financial and NFM data can be used to detect fraud. By doing so, we also implicitly provide evidence on whether systematic NFM manipulation is occurring at fraud firms. We also test whether NFMs can be used to detect when a firm’s reported financial performance does not accurately portray its economic performance. This study also expands the NFM literature by providing an empirical test of their potential to verify current financial results, as the extant NFM research looks at the ability of NFMs to predict future firm performance. We believe both roles of NFMs are valuable—one to validate and the other to forecast. We find that the relation between reported financial performance and NFMs can distinguish fraud from non-fraud firms.

Our fraud sample includes firms charged by the SEC with having fraudulently reported revenue in at least one 10-K filing. We do not include frauds that involve quarterly data and we also limit our sample to firms for which we were able to access the original 10-K filing and subsequent filings of restated data. Students enrolled in undergraduate and graduate auditing courses at three universities selected the non-fraud competitors and collected NFM data for our sample of fraud firms. Our sample includes NFMs that are quantitative, non-financial, non-employee related, and relate to firm capacity. Using this matched-pair sample, we document that fraud firms are more likely than non-fraud firms to report inconsistent revenue growth relative to their growth in NFMs. We analyze the growth from the year prior to the fraud to the first year of the fraud for each matched-pair. When we include a variable that measures the difference between a firm’s financial performance and its NFM performance in a model that includes other factors that have been found to be indicative of fraud, we find the difference is a significant discriminator between fraud and non-fraud firms. Thus, we provide evidence showing that comparisons between financial measures and NFMs can be effectively used to assess fraud risk.

Overall, our results provide empirical evidence suggesting that nonfinancial measures can be effectively used to assess the likelihood of fraud.

One of the phrases bandied about during the confirmation hearings for Judge Sonia Sotomayor’s nomination to the United States Supreme Court is “judicial activism” – a tendency of judges to use the cases they decide to implement their own notions of public policy. Of course, all recent Supreme Court nominees have steadfastly denied any shred of judicial activism and have uniformly maintained that the proper role of a judge, even a Supreme Court Justice, is to apply existing law, whether Constitutional, statutory or precedent, to the facts of the case before him or her. No one has been more outspoken against the evils of judicial activism than Chief Justice Roberts.

Now it appears that the Chief may be undertaking a bit of judicial activism of his own. The case is Citizens United v. FEC. The conservative group that sponsored Hillary: The Movie just before the Democratic primary is seeking to avoid or roll back the 2002 McCain-Feingold campaign finance law that prohibits the use of corporate funds to influence elections. Chief Justice Roberts and his conservative Supreme Court majority are getting ready to use Citizens United as the vehicle to overrule established precedent (and overturn carefully drafted legislation) and grant business corporations a constitutional right to use their funds to participate in political debate, not only on public issues, but even in the election of candidates to office. Such a move would be judicial activism on a grand scale!

1. Freedom of Speech for Corporations

Business corporations and their owners have participated in political life in many ways for many years. Corporate lobbying, campaign contributions by business leaders, “soft money campaign support” by businesses, the “revolving door” of businessmen and public servants: these are only a few of the many ways that corporations interact with politicians and political institutions in an effort to influence public action to their advantage. The American public has learned to live with a strong connection between business and politics.

In our paper Financial Structure, Acquisition Opportunities, and Firm Locations, which was recently accepted for publication in the Journal of Finance, we investigate the relation between firms’ locations and their corporate finance decisions. More specifically, we examine whether these choices are related to whether or not the firm is located within an industry cluster, that is, close to many of its industry peers.

We start by developing a simple model that describes the relation between a firm’s location, financial structure and acquisition activities. Our model assumes that firms located in industry clusters have more acquisition opportunities but also face greater competition from other potential acquirers. To take advantage of these opportunities, the firms in clusters maintain more financial slack, because by doing so they can bid more aggressively for acquisitions.

To test this model we examine the extent to which firms located in industry clusters are more acquisitive, the interaction between financial structure, location and acquisition activity, and finally, the extent to which firms in clusters maintain more financial slack. We find that after controlling for industry affiliation, firms located in clusters make more acquisitions, which is consistent with the idea that firms in clusters have more opportunities. In addition, we find that firms with more financial slack tend to make more acquisitions, which is consistent with firms maintaining more slack when opportunities are greater. More importantly, we show that the positive relation between acquisition activity and financial slack is stronger in clusters. If we assume that competition for targets is more intense in clusters then this finding is consistent with our model’s implication that debt plays a more important role when there is competition. Moreover, the fact that this relation is stronger for acquisitions of public targets and within industry targets, which are likely to attract more competition, provides further support for this implication of the model. Our results indicate that firms in clusters have less debt and hold more cash, and these relations continue to hold after controlling for the empirical determinants of capital structure. The relation between financial slack and location is particularly robust and economically significant. After controlling for other determinants of capital structure and cash holdings, firms located in clusters decrease their net market leverage by 19% and increase their cash holdings by 43% with respect to the sample averages.

Since an industry cluster is somewhat of a nebulous concept our empirical tests examine the robustness of our results with respect to a number of cluster definitions. One set of definitions uses the absolute number of firms within an industry in a metropolitan area. A second set defines clusters as the proportion of firms in an industry located in the metropolitan area. Finally, we do an in-depth analysis of the software industry (SIC code 737) since this is an industry with a large number of firms and a very well defined industry cluster in Silicon Valley. We document that firms in high tech cities and growing cities also maintain more financial slack.

(Editor’s Note: This post comes to us from Daniel J. Hurson of the Hurson Law Firm LLP, and relates to a recent client memorandum by Mr. Hurson, which can be found here.)

In a recent forum post, John F. Savarese and Wayne M. Carlin of Wachtell Lipton are critical of the SEC’s recent filing of a case against former CEO Maynard Jenkins of CSK Auto Corp., seeking payback of over $4 million in bonuses and stock sale proceeds. The SEC alleges that his company engaged in a massive accounting fraud, requiring a restatement, and thus Jenkins must payback these funds under Section 304 of SOX, the so-called “claw back” provision. Section 304, rarely used in the past by the SEC and never before against a CEO who was not personally accused of fraud, requires repayment to his company of certain bonuses and stock sale profits from a CEO or CFO whose company must make a restatement based on “misconduct.” The SEC pointedly did not accuse Mr. Jenkins of personal participation or knowledge of the fraud.

The Wachtell authors question the SEC’s taking action under Sec. 304 against a CFO not personally accused of fraud, calling it a “regrettable policy choice” and an “unfortunate contribution to the overheated atmosphere surrounding executive compensation.” Other commentators have also questioned the lawsuit, suggesting that it will have unfortunate consequences if successful. They too feel the statute is too ambiguous regarding whose “misconduct” is required to hit the CEO or CFO with claw back actions. The SEC, however, appears very much committed to the case and eager to test its new enforcement agressivness in an area with considerable potential deterrent impact.

In my recent client advisory, published thru the Mondaq news service, I argue the contrary. I believe there should be strict and aggressive enforcement by the SEC under the clear language of Sec. 304 to seek claw back from CEO’s and CFO’s who certify financial statements which ultimately have to be restated. There should be consequences to top managers who give these sweeping certifications to investors only later to have to issue restatements, often disclosing material weaknesses in internal controls or worse, which have the effect of making the certifications worthless. Since several courts have held there is no private remedy under Section 304, the SEC alone bears the responsibility to enforce this provision of SOX and give teeth to the certification requirements.

As I point out in the article, the legislative history, while sparse, supports a broad interpretation of Section 304 in which personal misconduct by the CEO or CFO, as opposed to management in general, is not required. Neither the Bush administration nor either branch of Congress, I submit, intended the statute to require proof that the individual managers from whom claw back is sought have to be proven guilty of personal misconduct. Rather, the fact that they preside over the filing of, and personally certify, financial statements which subsequently have to be restated, often leading to market value declines and substantial costs to the company, is enough to hold them responsible under Section 304 to repay compensation and profits which might not have been awarded or obtained had the truth come out or the weaknesses been corrected.

I further argue that going forward, the SEC should establish clear criteria for future cases, including a better definition of what kind of “misconduct” and materiality meets the threshold for claw back actions. The SEC should also, if it succeeds in the Jenkins suit, seriously consider revisiting the many restatements filed over the past several years, particularly among companies caught up in the present financial crisis, to see if other CEO’s and CFO’s have unduly profited from misstated financials, and initiate similar Section 304 claw back actions against them. In my view, shareholders who relied on the rosy certifications deserve no less.